Why Bank Downgrades Could Hurt Money Funds

By Jonnelle Marte

The decision this week by Moody’s to downgrade some of the world’s biggest banks may strike another blow to an investment that has been losing its appeal for many savers: the money-market fund.

After stock markets closed Thursday, Moody’s Investors Service announced downgrades on 15 global banks, including five of the six biggest U.S. banks by assets. While the action could raise borrowing costs for these banks, experts say the moves could also pose a threat to the $2.5 trillion money-market fund industry. Because money funds are required to invest only in highly rated short-term securities, the cuts mean a smaller pool of high-quality assets for fund managers to choose from, says Greg McBride, senior financial analyst for Bankrate.com.

As a result, some firms may be forced to hold more cash while they look for short-term securities to replace those from the banks. “That could further depress the returns they deliver to investors,” says McBride.

The downgrades come at a particularly tough time for the money fund industry. With the Federal Reserve keeping long-term interest rates near zero, fund providers have had to cut fees and expenses to keep the yield above zero; the average fund yields just 0.03%. Others have closed funds to new investors or shuttered them altogether. From January 2009 to April of this year, investors pulled $1.3 trillion from the funds, according to the Investment Company Institute, a fund industry trade group.

For investors looking for a dependable place to stash and grow their savings, advisers say there are better options. Online savings accounts, for example, can offer more attractive yields than money funds and insurance from the Federal Deposit Insurance Corporation, says Ron Pearson, a financial adviser in Virginia Beach. The online savings account from Ally Financial offers an annual percentage yield of 0.84% and has no minimum deposit. However the rate is variable and may change after the account is open. People who won’t need to access their savings for at least three months can consider a certificate of deposit, where the average 1-year CD on Bankrate.com is paying 0.76%.

Investors with a longer time horizon may also consider using short-term bond funds, where savers can keep their money relatively liquid while earning slightly higher returns, says Pearson. However, those savings wouldn’t be insured by the FDIC and could potentially drop in value, he says. The $1.7 billion Pimco Enhanced Short Maturity Strategy fund (MINT), for example, is pitched by the firm as a way to beat returns on money funds and invests in short-term, high-quality securities. The fund, which charges 0.35%, has returned 1% over the past year, according to Morningstar.

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